A decade after the credit crisis, investors are returning to where it all began. The U.S. mortgage sector, blamed in large part for the near-collapse of the global financial system, is now seen by many as a high-quality market forged by fire. Yet along with new players, new worries are emerging.
The mortgage-backed securities market, now mostly supported by U.S. government agencies, is undeniably safer than it was 10 years ago. Lending standards have improved as the share of riskier non-agency issuance has plunged. Meanwhile, the market has strengthened as more buyers seek stability—and opportunity—in a sector once tarnished by the housing-market implosion.
Yet as the overall market grows to a record size, participants remain on guard against signs of weakness. The Federal Reserve is retreating from the sector it rescued, raising concerns about a potential uptick in volatility. And as the housing recovery and rising interest rates have eroded affordability, and the administration looks for more ways to loosen regulations, some worry that lenders will revive the previous era’s bad practices.
“Certainly we’ve seen underwriting quality deteriorate” among government-sponsored enterprises, said Bryan Whalen, a portfolio manager at TCW Group Inc. in Los Angeles. Whalen favors non-agency bonds, particularly relative to high-yield corporate debt, given the “as-attractive if not better return profile, the direction of credit fundamentals is positive and supply is attractive.”
Non-Toxic
New affordability programs and loosening underwriting standards are showing up in current mortgage originations, TCW notes. For example, the share of conventional 30-year purchase loans originated with loan-to-value ratios above 90 percent has increased to 35 percent, from 5 percent in 2010, according to the asset manager.
Everyone remembers how subprime lending exploded in the pre-crisis years. Rising mortgage delinquencies and a nationwide residential and commercial market slump turned even highly rated securities—which financial engineering had helped proliferate—into toxic assets, ultimately leading to the collapse of Lehman Brothers Holdings Inc. Confidence in the financial system plummeted, triggering unprecedented government and central bank rescue efforts.
Fast forward to today and it’s not uncommon to hear investors say that U.S. mortgages offer an increasingly rare source of high-quality returns at this late stage of the credit cycle. Corporate spreads remain near historic lows, and the Treasury market faces a deluge of supply as the U.S. attempts to fund a growing fiscal shortfall. Rising yields have also helped curb a primary risk for MBS priced above par, by discouraging refinancing.
On the Upswing
The mortgage-backed market upswing is well-established, with positive returns on the Bloomberg Barclays U.S. MBS Index every year since the crisis, save 2013. Government assistance programs and the economic recovery helped lift home prices, and mortgage rates have risen. The most egregious high-risk products have virtually disappeared. And Fannie Mae and Freddie Mac—now entering their 11th year under government conservatorship—are maintaining quality control, with average credit scores higher than in 2007.
“The GSEs and the Federal Housing Finance Agency have done a good job of keeping credit standards where they should be while still innovating for an evolving market,” said Eric Schuppenhauer, president of Home Mortgage for Citizens Bank in Providence, Rhode Island.
The upshot is fewer mortgages, which has helped support the sector. Net issuance of agency MBS in the year through July stood at $130 billion, or 26 percent below the 2017 pace, according to Bank of America Corp. data.
The biggest structural change has been the Fed’s dominant presence. The central bank amassed as much as $1.78 trillion of MBS on its balance sheet under its quantitative-easing programs, which signaled to investors that it’s prepared to provide support if needed again.
The Fed’s actions have served to tamp down volatility for a market now in excess of $7 trillion. So much so that some investors worry the market is unprepared for the central bank’s withdrawal.
“We are developing a low-volatility addiction,” said Kirill Krylov, a senior portfolio strategist at Robert W. Baird & Co.
The Fed will allow its monthly MBS runoff to reach as much as $20 billion starting next month, part of an unwind that began in 2017. Policy makers have yet to announce long-term plans for the balance sheet, but some investors see a risk that more-aggressive deleveraging down the road could fuel volatility.
“Should the Fed decide to start actively reducing its balance sheet it will have very profound consequences in the mortgage market,’’ Krylov said. “The Fed has been buying the most negatively convex MBS. By not reinvesting its paydowns they will be poisoning the well by reducing the quality of the outstanding float.’’
New Direction
The FHFA’s plan to combine mortgages from Fannie Mae and Freddie Mac starting next year is also fueling speculation that the quality of loans will decline and hurt liquidity.
Uncertainty also surrounds the GSEs, which aren’t meant to remain wards of the state forever. Changing their status doesn’t appear to be at the top of the administration’s priorities, and market participants doubt that any reforms would abandon the all-but-explicit government guarantee on agency-backed securities. But with a Trump-appointed director set to take over next year, the government could look to cede some of its role in mortgage markets to allow more private-label activity.
In the meantime, investors are focusing on whether the FHFA will loosen lending standards further, to put home ownership within reach of more borrowers as housing prices exceed pre-crisis levels in many areas.
While a rebalancing to allow more private-label issuance could be healthy, “there is a risk that the FHFA will become more open to a further relaxation of the credit box,’’ Krylov said.
By Emily Barrett & Christopher Maloney
